As of this writing, the S&P 500 has gone 1,302 days without a correction of 10% or greater, the second longest run since World War II. As far as the untrained eye can see, risk appears to have disappeared from markets. The performance of the S&P 500 seems to dominate investors’ perception of prevailing risk in the market, despite explosive risk events in certain other asset classes – May and June 2013 saw the worst bond market rout in generations, certain commodity and resource assets lost more than half their value in 2014, and on October 15th 2014, 10-year Treasury volatility experienced a 7 standard deviation move from its intra-day norm (a move that statistically should only happen once every 1.6 billion years. . .no joke). In a diversified portfolio, however, “the market” is far more than just large cap US equities; it is the universe of investible assets. By that measure, risk is alive and well and diversification is more important than ever. This letter serves as a reminder to our clients why diversification is valuable in all market environments, not just those environments that are ostensibly risky. After all, getting you to your goal is the ultimate purpose of our work.
By our measure, risk is what could happen, not what does end up happening. When driving, the absence of an accident tells you nothing about how dangerous a trip could have been. We wear seatbelts and drive defensively because of how risky we know driving can be. The frequency that we drive from point A to point B without an accident, in theory, should not change the utility of a seatbelt and cautious driving. Investors, however, tend to behave differently; the better a market’s returns, the more investors generally want of the best performing asset class (more speed, less seatbelt), even though past returns tell you nothing about what could have happened or could happen in the future. We diversify because we know investing involves risks and that reducing those risks will dramatically improve your odds of reaching your goals:
Diversification reduces the number and magnitude of things that can go wrong. Diversifying over periods of time further amplifies this effect: since 1950, annual total returns for stocks have ranged from 51% to -37%, bonds from 43% to -8%, while a 50/50 blend of the two experienced swings of 32%and -15%. Extend the time horizon to any five-year period and those numbers are +28% / -2%, 23% / -2% and 21% / 1%, respectively:
All else equal, diversification improves risk-adjusted returns and can maximize overall returns over longer periods of time. Your arithmetic return is the simple average of your annual returns: ( -50% + 50% ) / 2 = 0%; your geometric return, on the other hand, reflects the reality of compounding capital over time (losing 50% and gaining 50% is hardly a round trip in the real world: volatility subtracts exponentially from one’s arithmetic returns). Mathematically speaking, by reducing volatility through diversification, while maintaining the same arithmetic return, one also increases the geometric return of a portfolio:
Diversification shortens your recovery time from losses. An all-stock portfolio took more than three years to recover losses after bottoming in March 2009. That’s just to get back to its October 2007 value, a four-and-a-half year round trip. A more diversified portfolio, on the other hand, took fewer than eight months to recover from the bottom, and just more than 2 years to return to its October 2007 peak value. While these differences seem small at first glance, the extra compounding time that diversification afforded the less risky portfolio means that it took roughly a full 6 years for the all-stock portfolio to finally catch up: